Clear Eyed Capitalist

The Value of Wall Street

A girlfriend sent me an article from last November’s New Yorker (Thanks jonathan for pointing out I mislabeled this as NYT initially) by John Cassidy that I’ve finally gotten around to reading, and as I ctrl+N my fourth email to tell someone about this article I realize it’s time to just blog. It’s one of those articles that reinvigorates my desire to have a meaningful portion of my portfolio dis-intermediated – IE invested as directly as possible in entrepreneurs and enterprises that generate value and not in the markets.

The article is about capital market dysfunction and how the financial services industry has expanded to absorb more than a quarter of all U.S. profits. Yeah, that’s pops my eyeballs a bit too. The article then goes on a tour of how much of that is “rent-seeking” – the official economics term for capturing value rather than generating it.

One longtime financial industry insider is sufficiently concerned about the problem that he endowed the Paul Woolley Center for the Study of Capital Market Dysfunctionality at the London School of Economics in 2007. The center publishes research like “Trading Frenzies and their Impact on Real Investment”. The New Yorker article mentions a 10-point manifesto that Dr Woolley released in May of 2010. It is advice to giant pension funds designed to restore efficiency to the public markets and shift investment emphasis away from rent seeking. Cassidy mentioned Wolley’s recommended cap on annual turnover, but my attention is drawn by his demands for total transparency of underlying investments and a commitment to only investing in publicly trading securities and refusing to make alternative investments. To ask large funds to do this is essentially trying to drive the private capital markets public. I think that would be a great thing and it seems likely to me that it would greatly improve market efficiency, but it’s hard to see how it can be a voluntary drive – it only works if a big enough segment of the market does it so it’s hard to be led by a few. Like the accusation oft made of “socially responsible investing” its goals seem realistically implementable only by regulation.

Two parts of his “manifesto” leapt out at me because they’re points I’ve heard friends locally make:

(Larina) that there’s a fundamental principal/agent problem where agents (the banks & investment agents) have better information than their customers and their interests are not sufficiently aligned.

(Leslie – check this guy out!) “Understand that all tools now used to manage risk and return are based on the discredited theory of efficient markets”.

There are lots of great quotes in Cassidy’s New Yorker article about the scourge of financial innovation: “’But these types of things don’t add to the pie. They redistribute it—often from taxpayers to banks and other financial institutions.’” attributed to Gerald Epstein at the University of Massachusetts. Citigroup is described as making a shift from trading significantly on their own account to emphasizing relationships with their clients. The fact that putting their client’s interest ahead of their own is a novel business strategy is a great illustration of how the financial industry has become a product industry instead of a service industry. And yet, what exactly is the added value of what they make?

It also touches on the shocking quick return to profitability of the Wall Street Banks -something that resonates particularly today with the recent headlines about GM. I almost need physical therapy for whiplash I feel on the short ride between the WSJ grousings about oppressive government interference and the triumphant crowing over profits. There’s also reinforcement for the argument that short-termism is a root problem – in this case because traders get compensated on short-term results despite the risk that the long-term results can destroy their employers. Heck, if the bonuses are big enough, even that’s not the trader’s problem.

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3 Responses

Interesting. It does seem that most of the value of the post-1980 financial industry comes from its ability to command payments and guarantees from the federal government. There has been no meaningful reform (Dodd-Frank being baby steps only).

In Ireland they have just voted down the long-standing government because of its support of financial companies. Maybe the US can take a lesson.